As most individuals are unaccustomed to managing large sums of money, it may be appropriate for plaintiffs to employ advisors to assist them with the investment of their awards. In these cases, it has often been argued that the cost of hiring such advisors should be added to the value of the award. This cost is referred to as a management fee or financial management fee.
The fees that are charged by financial advisors are almost universally quoted as a percentage of the total value of the amount that has been invested. For example, the fee charged by a bank or trust company for managing an investment of $1 million might be 2.0 percent of that investment, or $20,000 per year. This percentage normally declines as the size of the investment increases. For example, on an investment of $3 million, it might be 2.0 percent on the first $2 million and then 1.5 percent on the next $1 million.
The effect of the management fee is to reduce the net value of the rate of interest, or discount rate, obtainable by the plaintiff. For example, assume that a trust company is able to obtain a rate of return of 5.0 percent (after accounting for inflation) on an investment of $1 million, and that the management fee is 2.0 percent. The income earned in each year will be 5.0 percent of $1 million, or $50,000. But from that will be deducted a 2.0 percent management fee, or $20,000. Thus, the net return on the investment will be $30,000 ($50,000 – $20,000), which represents a 3.0 percent net rate of return on the investment.
When calculating the value of the plaintiff’s award, the financial management fee could be taken into account either by adding the dollar cost of the financial advisor to each year’s losses, or by discounting the future losses by the net rate of return on investments. The former approach requires the calculation of the management fee for each year in the future, whereas the latter requires only that the rate of return on investments be replaced by the net rate of return (3.0 percent is used in the example above instead of 5.0 percent). Thus, as both approaches produce the same estimate of the award, economists generally prefer to use the simpler approach: the net rate of return.
Assume that it has been agreed that plaintiffs should place their awards in a particular type of investment portfolio, and that the projected rate of return on that portfolio is, say, 4.5 percent. If the financial management fee is 1.75 percent, the appropriate discount rate would be 4.5 percent minus 1.75 percent, or 2.75 percent.
This is the basis of the argument that is often made in court: that a (financial) management fee must be deducted from the discount rate to obtain a “true” net discount rate.
Although this argument sounds reasonable, it is not – for the simple reason that in most cases in which financial experts testify concerning the value of “the discount rate”, it is a net discount rate to which they are referring. That is, they are referring to a rate from which the management fee has already been deducted. Thus, it is not necessary to deduct a further management fee from the recommended discount rate – the latter already includes a management fee.
What I wish to show in the following two sections is that whether it is necessary to deduct the management fee will depend upon the way the discount rate has been determined.
In the first of these sections, I will consider four situations in which the court has used testimony from expert witnesses to select the discount rate. In the second section, I will consider those cases in which the discount rate has been mandated by government regulation.
Court Selected Discount Rate
The courts have been clear that plaintiffs are expected to invest their awards in financial assets that do not expose them to unreasonable risk. For example, in its seminal decision in Lewis v. Todd (1980 CarswellOnt 617), the Supreme Court of Canada approved of the expert’s use of “high grade investments [of] long duration.” [para. 17] Financial experts have generally held that this implies that the plaintiff’s award should be invested in a balanced portfolio of conservative financial assets – for example in a mix of government bonds, highgrade corporate bonds, and “blue chip” stocks.
In this section, I will consider four approaches that plaintiffs could take to the investment of their awards; and investigate whether it would be appropriate to deduct a management fee in each of them. These approaches assume that the plaintiff will either:
- Purchase mutual funds that spread their investments across balanced portfolios of financial assets.
- Employ a financial advisor to assist them with decisions concerning their investments.
- Use their own expertise to invest in financial markets.
- Purchase a structured settlement.
Under the first three of these approaches, I assume that the plaintiff, and his or her advisors, will attempt to balance two goals: maximize the rate of return on investments, and minimize the risks associated with the purchase of financial assets. This balance is achieved by investing in a balanced portfolio of assets spread across a range of potential instruments. (Under the fourth, structured settlement approach, the plaintiff leaves the choice of investments to the provider of the structured settlement.)
Balanced portfolio funds: One method of achieving a balanced portfolio is to purchase a type of mutual fund called a balanced portfolio fund. Each of these funds – which are offered by all of Canada’s banks, by many investment houses, and by insurance companies – invests in a balanced blend of asset classes. These funds offer numerous advantages to the plaintiff. They reduce risk by spreading their investments across different types of assets, in different industries, and different countries. They offer clearly identified choices concerning the degree of risk that the plaintiff is willing to accept, often ranging from “very conservative“ to “aggressive growth-oriented”, and the selection of the assets to be incorporated in each fund is made by experts who are supported by teams of researchers.
Furthermore, balanced portfolio funds offer the attractive feature that the rates of return that they have earned are publicly available. Thus, not only can the plaintiff-investor determine easily what any fund’s performance has been; but the rates of return on those funds can be used by the courts as objective measures of the returns that are available to plaintiffs when they invest in conservative, balanced portfolios.
The interest rates that are reported publicly, on balanced portfolio funds, are net of management fees. For example, if a fund earns 4.5 percent on its investments, and the fund’s operators charge a fee of 2.0 percent, the published rate will be 2.5 percent. It is information concerning these published rates – that is, rates that are net of the fund operators’ rates – that Economica uses when discounting plaintiffs’ future losses. [See Selecting the Discount Rate, Expert Witness, Vol. 21, Spring 2017.] As these rates are net of the operators’ fees, there is no need to add a “management fee.”
Financial advisor: Instead of purchasing a mutual fund “off the shelf,” the plaintiff could employ a financial advisor to purchase a balanced portfolio of investments, specific to the preferences of the plaintiff. Generally, these advisors charge a fee that equals approximately 1.0 to 2.0 percent of the value of the assets that they are managing. Is there an argument for adding the cost of this advice to the plaintiff’s award, as a management fee? I will argue that the answer is “no.”
To see why, consider the following example: assume that a financial advisor who charges a management fee of 2.0 percent is able to obtain a rate of return of 5.0 percent. The net rate of return received by the advisor’s clients will be 3.0 percent. [For example, $100,000 invested at 5.0 percent will generate a return of $5,000 per year and, with a management fee of 2.0 percent, will cost $2,000 per year. Thus, there is a net gain of $3,000, which is 3.0 percent of the invested amount.]
In this case, the appropriate discount rate will be the net rate of interest obtained by the advisor, or 3.0 percent. For example, to determine how much would have to be invested today to replace a $103,000 loss a year from now, one would divide $103,000 by 1.03 (= 1 + the interest rate), to get $100,000. When future losses are discounted by this rate, the costs of the advisor’s services have been accounted for in the calculation – the $3,000 gain after one year equals the return on the investment, $5,000, minus the advisor’s fee, $2,000.
Thus, if the discount rate that is used by the court to calculate the value of the plaintiff’s award equals the net investment return obtainable by the financial advisor, no additional allowance needs to be made for a management fee.
Although the rates of return obtainable by financial advisors are not publicly available, a reliable objective measure of that rate is the rate of return on balanced portfolio funds. As
independent financial advisors generally rely on the same research that is available to the operators of mutual funds (they usually work for the same financial institutions), they can be expected invest in portfolios of financial assets that are similar to those that are contained in balanced portfolio funds. They can, therefore, be expected to generate similar rates of return net of management fees.
If that is true, then the estimate of the return available to independent advisors includes an allowance for the management fee, and no additional management fee need be awarded.
Self investment: In those cases in which plaintiffs are expected to use their own skills to invest their awards, there will be no (or only minor) management fees and, hence, no call for such fees.
Structured settlement: The cost of any structured settlement includes the cost to the issuer of managing that settlement. Hence, again, there would be no need for an additional management fee.
Summary: I can find no situation in which it would be necessary to award a management fee to a plaintiff who is mentally competent.
Mandated Discount Rate
An argument might be made for the award of management fees in those cases in which the discount rate mandated by the government exceeds the rate predicted by the experts before the court.
Assume, for example, that the mandated rate was 3.0 percent and that the best evidence before the court was that the net rate of return available on a balanced portfolio of funds was 2.0 percent. It could be argued that the difference between the two rates had arisen because the mandated rate reflected the rate of return available before deduction of management fees. In that case, it might be appropriate to award a management fee of 1.0 percent, to bring the net discount rate to 2.0 percent.
It must be pointed out, however, that the rates currently mandated in British Columbia, Ontario, and Saskatchewan are significantly lower than the net rates available on balanced portfolio funds. Hence, although there is a case for awarding management fees in some cases, the conditions for those cases do not exist at this time.
In virtually every situation in which financial experts testify concerning the value of the discount rate, the rate of return that they refer to is net of the cost of investment. Hence, it is not necessary to deduct a financial management fee. And, although such a deduction might be necessary in cases in which a mandated discount rate had been used, the rates that have been mandated in Canada in recent years are so low that it must be concluded that they are also net of management fees.
Christopher Bruce is the President of Economica; he has a PhD in economics from the University of Cambridge